Why asset allocation matters (a lot)
What is asset allocation? When we invest, we buy an asset. There are many different types of financial asset – at the most basic level, equities, bonds and cash.
My name is Ken Volpert. I am Vanguard’s head of investments in Europe.
When we talk about asset allocation, what we are deciding how much of our total assets will be in equities, how much in bonds and how much in cash.
The question I want to ask here is: why does it matter? And the reason I want to ask it is because it matters a lot … more than most people realize. It is probably the most important investment decision you will make.
Let’s look at two portfolios – they both start at a value of £10,000 and 10 years later, one is worth £20,000 and the other is worth £15,000. That £5000 difference in the end value – most of that is due to asset allocation – the choice between equities, bonds and cash.
This has been shown to be true in a number of academic studies.
Possibly the most influential was the study in the US entitled Determinants of Portfolio Performance by Brinson, Hood and Beebower. It showed that over a 10 year period, 1974 to 1983, 94% of the variation in returns between pension plans was due to their asset allocation … the percent of their portfolio held in equities, bonds and cash … and not due to their selection of managers or securities.
Other similar studies have come to similar conclusions, such as a study we did at Vanguard that covered a much longer period, 50 years, from 1962 to 2011. It looked at the monthly returns of 518 balanced funds using data from Morningstar.
Different studies, using a variety of fund types and time horizons, come up with different results. But they all point to one conclusion – somewhere around 80%-90% of the return difference between one investor’s portfolio compared with another is determined by the long-term mix of equities, bonds and cash – in other words, by asset allocation.
Notes: Vanguard research paper The Global Case for Strategic Asset Allocation (Wallick et al., 2012). Calculations based on monthly returns for 518 US balanced funds from January 1962 through December 2011, using data from Morningstar. Determinants of Portfolio Performance (Brinson, Hood, Beebower, 1986)